Academic journal article Journal of Business Strategies

Dynamic Effects of U.S. Budget Deficit and Labor Productivity-Real Wage Gap on US Stock Market Performance

Academic journal article Journal of Business Strategies

Dynamic Effects of U.S. Budget Deficit and Labor Productivity-Real Wage Gap on US Stock Market Performance

Article excerpt


This paper investigates the dynamic effects of annual U.S budget deficit as a ratio of GDP and labor productivity-real wage gap on US stock market performance. The sample period runs from 1950 through 2012. The standard cointegration methodology is appropriately applied. All the aforementioned variables are nonstationary in levels revealing 1(1) behavior. The coefficient of the error-correction term of the vector error-correction model (VECM) has expected negative sign with statistical significance confirming long-run unidirectional causality stemming from the independent variables to the stock market return. However, the speed of adjustment towards a long-run equilibrium is slow as reflected in the low numerical coefficient of the error-correction term. The evidences on short-run interactive feedback effects are also very weak.

Keywords: Budget Deficit, Productivity-Real Wage Gap, Unit Root, Cointegration, Vector Error-Correction Model

JEL classification code: E60, G10


U.S. Federal budget deficits have been perennial at sustainable levels throughout the US history excepting several years, occasionally. The net effect of the budget deficits on stock market returns is confounding and uncertain through interest rate and price channels depending on the methods of financing. This issue remains a puzzle inspiring numerous empirical studies. In theory, rising deficit boosts federal demand for loanable funds that, in turn, lifts interest rate and crowds out private investment. This decline in private investment reduces corporate capital stock with which to work. This contracting capital stock decreases future earnings growth and cash inflows. In addition, rising interest rate used as a discount factor depresses stock prices. Monetization of increases in budget deficits through quantitative easing lowers interest rates and causes higher expected inflation. Both exert opposing influences on stock prices.

In finance, the valuation of stocks depends on the expectation of the current and future cash flows from equities, the risks inherent in those flows, and rate at which those flows are discounted. Stock prices are also influenced by changes in economic activity, interest rate, and inflation, among other macroeconomic fundamentals. Their net effect on stock market at some point of time is ambiguous. Efficient market hypothesis in weak-form further claims that budget deficits have little effect on future stock prices as the past deficits are already incorporated in the current stock prices. Stock price behaviors have important bearings on private sector capital formation, market liquidity, allocative efficiency and economic prosperity meriting further empirical inquiries.

The unprecedented rise in U.S. budget deficit and uncharted behavior of U.S. stock market during 2008-2010 renewed interest in studying further the relation between budget deficits and stock prices. Economic theories are unsettling to provide a clear explanation to this uneasy and complex relationship. The effects of rising budget deficits due to income tax cuts or federal spending spree or both on stock prices primarily depend on the state of the economy and the methods of financing the deficits. To explain further, (i) increase in income tax reduces disposable income to spend on consumption goods. This reduces aggregate demand. Given the aggregate supply constraint, prices of consumer goods decline resulting in depressed corporate earnings and hence lower stock prices, ii) financing by federal borrowing from loanable funds market raises interest rate that, in turn, reduces stock prices, and (iii) partial or full monetization of deficits by accommodative monetary easing lowers interest rate without risk of surging inflation, if the economy is at less-than-full employment. This will help lift stock prices. Furthermore, if the economy is at full employment, monetary easing will raise the fear of future resurgence of inflation with dampening effects on stock market as rational investors will reshuffle their portfolios by reallocating funds from financial assets to real assets for hedging purposes. …

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